4 Market Conditions to Consider Before Going Active

  • When deciding whether to change course and allocate to an active strategy (even one that uses passive instruments, like sector rotation) versus a purely passive or index fund, market conditions matter. That’s because certain conditions can favor active strategies and their ability to generate alpha.

Below we describe four factors that can drive alpha opportunities and assess whether these "active four" are trending in favor of active management. While this applies across most markets, we are providing an update on just the US equity markets, the typical protagonist in the active vs passive debate.

The active four:

1. Volatility:
Periods of linear trending volatility may make conditions less attractive for active managers, while bouts of volatility that affect investor sentiment may lead to a more favorable environment. Unforeseen market disruptions may create the opportunity for active managers to harness trends and navigate the market's challenges.

Current state:
After an extremely tranquil 2017, equity market volatility was back to normal in 2018, as shown below. Episodes of volatility were triggered by concerns about China-US trade wars and a slowdown in the US economy. Looking ahead, as economic growth decelerates, many macro events (including the US government shutdown, Brexit negotiations, trade tensions between China and the US, and differences between market and Federal Reserve expectations for interest rates) will continue to drive volatility, potentially creating more opportunities for active managers.


2. Correlations:
A highly correlated environment where all stocks are moving alike undermines the effect of selecting individual stocks and the ability to generate alpha.

Current state:
As shown below, US large-cap stocks saw low correlations in 2016 and 2017. However, the dynamic started shifting in 2018 and correlations spiked as more political and macroeconomic uncertainties took the center stage, driving the market to move holistically. This dynamic could be less favorable to active management.


3. Dispersion:
Dispersion measures the return differential among various stocks. A wider dispersion among assets provides more opportunities for managers to rotate in and out of leaders and laggards, generating alpha.

Current state:
Dispersion has been on an upward trend since early 2017 and crossed above its long-term median level in 2018, which is constructive for stock picking. High return differences augment the impact of overweighting winners and underweighting losers.


4. Breadth:
Narrow market breadth, where only a few winners support index gains, makes it harder for stock selection strategies to outperform. One way to gauge market breadth is to assess overall index performance against performance trends among underlying constituents. When an index is trading above its moving average in an environment of wide market breadth, we should expect a great number of its constituents to be trading above their respective moving averages.
To calculate the baseline percentage of constituents that should be trading above their moving average given a certain index level relative to the index’s moving average, we employ linear regression analysis and use historical percentage of constituents trading above their 50-day moving averages and the difference between the S&P 500 daily index level and its 50-day moving average. If the actual number of constituents trading above their moving average is less than the baseline, it indicates narrower market breadth.
Current state:
The chart below shows the differences between the actual number of stocks above their 50-day moving average and the projected baseline. A positive number indicates wide market breadth. As shown, the market breadth has been narrow for the most part of 2018, which may limit alpha opportunities and create a headwind for active managers.


Taking the Active Four out for a Drive

As illustrated here, there are many factors that influence an active manager's success. Before you implement an active strategy or review an underperforming one, be sure to evaluate the market environment—it can be a real game-changer.

As of now, these four metrics show a balanced environment for active managers: narrow breadth alongside increasing correlation, volatility and dispersion.

Important Risk Information

This document may contain certain statements deemed to be forward-looking statements.  All statements, other than historical facts, contained within this document that address activities, events or developments that State Street Global Advisors' expects, believes or anticipates will or may occur in the future are forward-looking statements.  These statements are based on certain assumptions and analyses made by State Street Global Advisors in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein.  Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond State Street Global Advisors' control.  Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors' express written consent. The views expressed in this material are the views of Matthew J. Bartolini  through the period ended March 2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Actively managed ETFs do not seek to replicate the performance of a specified index. Volatility management techniques may result in periods of loss and underperformance, may limit the Fund's ability to participate in rising markets and may increase transaction costs. The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.